Key investment professionals review the first half of 2014 and share their insights into what may be ahead for the second half of the year.
Zach Pandl, Portfolio manager and strategist
Government bond yields declined in early 2014, both in the U.S. and in other developed market economies. This surprising change in course after increases in 2013 caught many investors off guard. In our view, declining interest rates reflect renewed pessimism about the global economic recovery, as well as easy monetary policy from the Federal Reserve, European Central Bank and Bank of Japan.
The U.S. economy has made considerable progress in the five years since the recession ended. Inflation, unemployment and broader measures of labor utilization have all moved closer to the Federal Reserve’s targets. Against this macroeconomic backdrop, interest rates in most developed markets look unsustainably low. We therefore expect meaningful increases in the second half of 2014 as bond markets begin to reflect the increasingly mature recovery.
James Dearborn, Head of municipal bonds investments
Municipal bonds had a strong first half of 2014. While the drop in Treasury rates since the end of 2013 is the primary reason for the strong performance, there are specific municipal bond market factors that bolstered tax-exempts’ returns including: a dearth of new supply, new and higher taxes, a resurgent demand created by investor appetite for attractive taxable-equivalent yields, and a grudging acceptance by retail investors that municipal credit quality is improving.
For the remainder of 2014, we anticipate that, with the strong performance year to date, most of the return opportunity in tax-exempt municipal bonds will be from coupon payments. Beyond attractive taxable-equivalent yields, the technical factors that propelled municipals in the first half of the year are likely to persist through the remainder of 2014, providing stability to the asset class, even if we experience an increase in Treasury rates. We anticipate that supply will remain moribund and that investor appetite will continue unabated. We view any sell-off caused by “one-off” credit headlines, such as concerns around the State of Illinois, the City of Chicago or other poorly managed state and local borrowers, as a buying opportunity, as we believe the vast majority of municipal issuers are experiencing credit strengthening with improving tax collections and still restrained spending.
Marie M. Schofield, Chief economist and senior portfolio manager
The discouraging drop in first quarter gross domestic product is a reminder that some headwinds persist despite the improvement in underlying economic trends. Cold weather and an inventory correction were blamed for most of the decline, and the reversal of these drags will temporarily lift second quarter growth to above trend. Importantly, housing has become less of an accelerator for the recovery, as affordability was dented due to higher interest rates and home prices. Consumer spending appears steady, although consumers appear less inclined to add to debt, particularly for discretionary purposes, with income gains remaining tepid at best.
Economic trends still appear likely to pick up in the second half of 2014 to near 2.75%, as drags continue to unwind. Positives for the outlook include a reversal of the brake from fiscal contraction, further gains in capital spending and manufacturing activity, and a diminishing trade imbalance as U.S. exports are bolstered by energy. Housing represents a risk factor, particularly if interest rates shoot higher again, underscoring how sensitive growth is to the level of rates. In addition, slower global growth and rising geo-political risks present downside risks to growth, although supportive central bank actions will continue and perhaps accelerate, particularly in Japan, China and the eurozone.
Colin Lundgren, Head of fixed income
2014 has been a happy new year for taxable fixed-income investors. After experiencing mostly negative total returns in 2013, the surprising combination of lower interest rates and narrower risk premiums resulted in strongly positive total returns across most sectors in the taxable bond market. Equally surprising, some of last year’s weakest performers — such as emerging market bonds and U.S. inflation protected securities — were the best performers in the first six months of 2014. Sectors and strategies that had the most interest rate risk and/or offered the most yield, won the day.
But is this sustainable? Probably not.
The second half of 2014 may produce negative price pressures for taxable bonds from potentially rising interest rates and wider risk premiums. We believe several factors that caused interest rates to move lower in the early part of the year may be less supportive of lower interest rates in the months ahead. In addition, investors pushed yields to historically low levels in many non-Treasury sectors and those investments may be susceptible to a correction for valuation reasons, or at least will not produce strongly positive excess returns. In short, if the first half of 2014 produced “coupon plus” returns for taxable fixed-income investors, the second half of the year may generate “coupon less” returns.
Robert McConnaughey, Global research director
Year to date through May, the U.S. major market indices are up low-to-mid single digits. Overall market volatility has been very low by historic standards and has trended down through the year. Beyond the high level averages, 2014 has seen some violent moves at a factor and industry level. After a strong start to the year, smaller cap and higher momentum names had a dramatic sell-off in March and April before rebounding in May. Along the same lines, we saw a momentum reversal across the world with 2013’s market darling, Japan, selling off while 2013’s laggard emerging markets rebounded strongly. European markets followed a similar pattern with core markets performing generally in line with the U.S. and peripheral markets outperforming.
Developed world equity markets do not leap out as intuitively cheap until one compares their valuations to the fixed-income markets, which are trading at very long-term historical low yields. On that relative basis and given reasonably strong balance sheet and cash flow characteristics (specifically in the U.S.), equities look pretty attractive. Emerging market valuations do look more attractive on an absolute as well as relative basis, even when accounting for the deserved low valuations of some of the large market cap state owned enterprises in China and Russia. Overall global economic conditions and resulting revenue growth remain modest to anemic. We see a world of increasingly differentiated investment outcomes based on competitive positioning of businesses.
Jeffrey Knight, Global head of investment solutions and asset allocation
The pronounced deceleration in global economic growth that characterized the early weeks of 2014 has given way to the positive gradual trajectory that we expected for this year. Since early February, as economic data have stabilized and even strengthened a bit, stocks have recovered all of their early year losses and once again, in many markets, reclaimed record prices. Interestingly, two out of favor asset classes have kept pace with developed market equities this year, namely, government bonds and emerging market equities. Very few asset classes have failed to participate in year-to-date gains, with investments like Japanese equities or certain specific commodities providing the exceptions to the overall bullish rule of the first half of the year.
The balance of the year could prove more volatile. The Federal Reserve appears undeterred in its tapering of large scale asset purchases. Bond yields, and market volatility overall, would seem to have only one direction to move, and that is higher. Finally, the degree to which a slowing growth profile in China resounds across other developing economies remains to be seen. We expect further gains to accrue in the near term, but favor a well-balanced and risk-aware portfolio strategy to provide resilience if today’s market calm elapses over the balance of 2014.